Einstein allegedly called compound interest the eighth wonder of the world. Benjamin Franklin defined it more poetically: “Money makes money. And the money that money makes, makes money.”
Here’s another take: With the passage of time, compound interest turbocharges the growth of your savings and investments—and balloons the debt balances you owe. That means the sooner you start saving, the more time your money has to grow. And the longer you let debt go unpaid, the more you end up owing.
“The key is knowing how to harness the power of compound interest for your savings and investments, while keeping it in check when it comes to debt,” says Taylor Kovar, CFP, the CEO and founder of 11 Financial in Lufkin, Texas.
Compound interest is just another way of saying that time is money. Whether you’re saving for a dream vacation or planning for retirement, harnessing the power of compound interest means you’ll reach your financial goals more quickly.
How does compound interest work?
Whether you’re thinking about savings or debt, principal represents the money you start out with, in a savings account or a loan balance. Think of it like a snowball about to start rolling downhill. Once it gets going, the snow it picks up along the way is the interest you earn or owe—at first the snowball grows imperceptibly, but the longer it goes the faster it becomes a giant avalanche.
Let’s say you had $5,000 in a savings account that earns 5% in annual interest. In year one, you’d earn $250, giving you a new balance of $5,250. In year two, you would earn 5% or $262.50 on the larger balance of $5,250, giving you a new balance of $5,512.50.
Thanks to the magic of compound interest, the growth of your savings account balance would accelerate over time as you earn interest on increasingly larger balances. If you left the initial principal of $5,000 in the savings account for 30 years, earning a 5% annual interest rate the whole time and never adding another penny, you’d end up with a balance of $21,609.71.
Now consider this example in the mirror, where instead of savings the balance was debt owed on a loan. It illustrates why maintaining debt balances over time can be so dangerous. If you’re not careful, your debt snowball can quickly spiral out of control.
The frequency of compounding—when the interest is added to the principal—can be daily, monthly, or annually, with more frequent compounding generally resulting in higher returns. For example, a $3,000 savings account earning 2% interest compounding annually would grow to $6,625 after 40 years. However, if compounded monthly, it would reach $6,673. While the difference may seem small initially, it becomes more significant over time, especially if you continue contributing to the account.
“By starting early and staying disciplined, you can let your money grow exponentially over time. But when managing debt, don’t let compound interest work against you—get ahead of it with a smart repayment strategy,” says Kovar.
Compound interest is a factor you need to understand when thinking about a whole range of financial instruments.
- Savings accounts: These bank accounts earn interest on savings that compound daily, monthly, or yearly. They offer easy access to funds through transfers and withdrawals.
- Certificates of deposit: CDs typically offer higher returns than traditional savings accounts but require you to leave the funds untouched for a fixed period. Interest usually compounds daily or monthly.
- Stocks: Dividend reinvestment is a powerful strategy that can significantly boost long-term returns for stock investors. When you reinvest dividends, you use the cash payments from companies to purchase additional shares of the stock instead of taking the money as income. This process creates a compounding effect that can dramatically increase your investment over time.
- Real estate: Real estate investments benefit from compound growth through property appreciation and rental income reinvestment. This compounding effect can lead to significant wealth accumulation over time.
- Student loans: While federal student loans accrue simple interest, some private lenders charge compound interest. This process, called interest capitalization, can make it challenging for borrowers to pay down their principal balance.
- Credit cards: These often compound interest daily or monthly on outstanding balances, making it easy to fall into a debt trap if not managed carefully.
Compound interest and credit card debt
If you’re carrying credit card debt, it’s going to take forever to pay off if you’re just covering the minimum payments—this is because of compound interest adding to what you owe every day.
“A common mistake is not realizing how much compound interest adds up, especially when it’s working against you,” says Kovar. “For example, with credit card debt, the interest compounds daily. If you only make the minimum payment, the majority of your payment goes toward interest, not the principal.”
This results in longer repayment periods and more interest paid over time. The best way to avoid this is to pay off high-interest debt as quickly as possible to minimize how much interest accrues.
Many financial advisors recommend the debt avalanche approach, which involves paying off your highest-interest debts first, such as credit cards, before tackling anything with lower interest. If this feels overwhelming, others recommend the debt snowball method: Paying down your smallest debt first, giving you a good feeling and confidence that can “snowball” into paying down your larger loans.
Time is of the essence
If you want to take advantage of compound interest, the best thing you can do is let your investment sit as long as possible. That’s why financial advisors are so bullish on starting your retirement fund as early as you can.
“The average return of the S&P 500, assuming reinvested dividends, over the last 50 years is about 10.13%,” says Wendy Baker, Assistant General Counsel, Retirement Products & Compliance at Human Interest. “If you were to contribute $39 per biweekly paycheck, here’s what that could look like if you retire at age 65:
- If you start saving at age 20, you could save $322,126 by age 65
- If you start saving at age 30, you could save $152,828 by age 65″
How long will it take my money to double?
For a quick and dirty estimate, you can use the rule of 72:
“The Rule of 72 is a quick way to estimate how long it will take for an investment to double, based on a fixed annual interest rate,” says Kovar. “You divide 72 by the interest rate. For example, if your investment earns 6% annually, it would take about 12 years for it to double (72 ÷ 6 = 12). The Rule of 72 illustrates the power of compound interest: The longer your money stays invested, the more it grows.”
For a totally accurate measurement, you can use a compound interest calculator (there are plenty of free options available). Just make sure it can factor in whether your interest compounds daily, monthly, or yearly to get the most precise calculation.
The bottom line
Compound interest is a powerful financial concept that can significantly impact your wealth, both positively and negatively. It’s crucial to understand how it works and its effects on various financial instruments.
